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If you were to walk down Fifth Avenue and see a store displaying a white apple suspended in a large glass case, more likely than not you would immediately think of the California-based tech giant who shares its name with the nutritious snack. Similarly, if the person walking in front of you on your way to the Apple store lifted her heel to reveal a candy-apple red shoe sole, more likely than not the name Christian Louboutin would pop into your head. How is it that we can so easily forget the name of a person we were just introduced to, yet simple ideas like a picture of fruit or the color of a shoe bottom could instantly trigger a specific company in your mind? The answer: branding.

Companies collectively spend billions of dollars on branding each year to make symbols like Louis Vuitton’s “LV” and Nike’s famous swoosh synonymous with their respective brands and the reputation that accompanies them. The troves of money invested in branding appears to be well spent, as trademarks are afforded strong legal protections and are accompanied by the profitable prospect of licensing those unique marks to third parties. Licensing has become such a profitable revenue stream that it is now some designers’ main source of profit. As of 2015, roughly 90 percent of Calvin Klein Inc.’s $160 million worth of annual sales came from trademark licensing.1

Yet, surprisingly, the law stops short of offering special protections to the licensees of those trademarks in the event of a bankruptcy of the licensor—a situation that has the potential to turn a pair of Gucci brand sunglasses into trademark-infringing knock-offs overnight. Vulnerable trademark licensees had a glimmer of hope based on a 2012 Seventh Circuit opinion that was shaping up to be the Greek heroine for this area of intellectual property that has arguably fallen through the cracks of bankruptcy law. But a January opinion fresh out of the First Circuit might just be the arrow into trademark licensees’ Achilles’ “Louboutin” heel that will keep licensees unprotected and at risk in bankruptcy. The resulting circuit split, which leaves trademark licensees wary, could now garner the attention of the Supreme Court.

How did we get into this mess?

To understand how we arrived at this point, it is important to explore briefly the origins of IP protections in bankruptcy law. In 1985, in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., the Fourth Circuit held that a debtor-licensor’s rejection of a patent license denied the licensee any right to continue to use the licensed technology.2 The court reasoned that the decision was consistent with the Bankruptcy Code and that it was the job of Congress, not the courts, to offer licensees relief.3 Shortly after Lubrizol, Congress got to work to change that result by enacting section 365(n) of the Bankruptcy Code, which laid out the respective rights of licensors and licensees of “intellectual property” in the event of a license rejection in bankruptcy. Yet, Congress omitted trademarks from the definition of intellectual property (section 105(35A) of the Bankruptcy Code)—the result of which is a lack of any statutory protection for trademark licensees when a licensor decides to reject a license that is an executory contract.

The repercussions of Congress’ action (or lack thereof) were exemplified in 1994 in Licensing by Paolo, Inc. v. Sinatra (In re Gucci).4 After leaving the Gucci brand, Paolo Gucci started his own fashion company where he licensed the “Designed by Paolo Gucci” trademark to different product manufacturers. This resulted in numerous lawsuits by other members of the Gucci family who were displeased with Paolo’s use of the Gucci name. When Paolo filed for chapter 11 in 1994, Guccio Gucci (the Gucci Company) submitted a bid to purchase the “Designed by Paolo Gucci” trademark. After Guccio Gucci submitted the winning bid for the trademark, the sale order approved termination of the licensing agreements under the Paolo Gucci name, which included contracts to use the brand name on handbags, wallets, luggage, watches, and belts. When the sale order was appealed on the grounds that Guccio Gucci was not a good faith purchaser under section 363 of the Bankruptcy Code, the court found in favor of Guccio Gucci because the Bankruptcy Code is silent on the issue of whether trademark licensees are entitled to retain their rights post-bankruptcy. The licensees immediately lost the right to use the trademark, whether or not they had invested in inventory that already used the mark. Based on this example alone, it is clear why trademark licensees would be uneasy about the current state of the law—what today is a $300 pair of sunglasses could be worth pennies tomorrow.

The Current Debate

Fast forward to 2012 when Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC enters the runway. In this case, Lakewood, a company that sold brand-name box fans, contracted with Chicago American Manufacturing (“CAM”) to have CAM manufacture the box fans that Lakewood would then sell. Concerned about Lakewood’s financial position, CAM included a licensing provision that permitted it to sell the Lakewood-brand box fans on its own in the event that Lakewood could not fulfill the purchase. Lakewood subsequently filed for bankruptcy and Lakewood’s assets were purchased by Sunbeam Products. Sunbeam had no interest in the box fans but did not want CAM to sell the fans, so as part of the sale of the Lakewood business, the trustee rejected the CAM contract with the license. CAM continued to sell the box fans despite the contract rejection and Sunbeam subsequently filed suit.

The Seventh Circuit, in deciding the case, turned to the legislative history behind Congress’ enactment of section 365(n). A Senate committee report on the bill revealed that Congress did not intend to leave trademarks unprotected, but simply deferred action on the subject until it had more time to study and better comprehend trademark law.

Finding in favor of CAM and utilizing the legislative history to make its point, the Seventh Circuit held that the breach resulting from a contract rejection under section 365(a) was not the functional equivalent of a rescission, but instead allowed the other party’s rights to remain in place—including trademark licensing rights. The court went on to say that a rejection merely frees the estate from the obligation to perform under the contract and has no effect on its continued existence.5 The debtor is simply freed from being subjected to an order for specific performance.

What appeared to have been a major win for trademark licensees has now been stunted by the First Circuit’s holding this year in Mission Product Holdings, Inc. v. Tempnology, LLC (In re Tempnology, LLC), which favored the previous categorical approach of leaving all trademark licenses unprotected from court-approved rejections.6 The First Circuit justified its ruling by arguing that allowing the licensee to continue to use the trademark would effectively require the debtor to monitor and exercise control over the products for quality assurance—an obligation that arises out of trademark law. The monitoring obligation for trademarks, the court argued, is unlike the licensor’s obligations for other intellectual property because trademarks are “public-facing messages to consumers” and monitoring is required “to ensure that the public is not deceived as to the nature or quality of the goods sold.” A licensor’s failure to monitor and exercise control over a trademark license jeopardizes the continued validity of the license, which makes the licensor’s obligation a real and concrete duty. It is this monitoring obligation that the court found to be too burdensome on the debtor to allow the licensee to retain its rights post-rejection.

Clarification to this prominent circuit split may come sooner than you think. On June 11th, Mission Product Holdings Inc., the harmed licensee in Tempnology, filed a petition for writ of certiorari with the Supreme Court requesting that it review the First Circuit’s opinion—a decision that Mission argues in its petition has worsened the already prominent circuit split. There is an argument that the monitoring obligation that the Tempnology opinion advances is incomplete because of the history of courts relaxing the licensor’s obligations in a trademark licensing agreement. For example, in Syntex Labs., Inc. v. Norwich Pharmacal Co. the Southern District of New York district court held that a licensor’s monitoring and quality control requirements were sufficiently met through reliance on the integrity of the licensee.7 In this scenario, allowing the licensee to continue to use the license post-rejection would create no actual obligation to perform on the part of the debtor-licensor—which is a major factor on which the Tempnology holding relies. If the Supreme Court is willing to accept this modified application of the monitoring obligation, it just might result in a pro-licensee decision.

For now, we are left to wonder whether your next pair of designer shoes or eyewear could be turned into a “limited edition” overnight. Stay tuned!

Weil Summer Associate Matthew Rayburn contributed to this post.

The post From Gucci to Knock-off: How Bankruptcy Leaves Trademark Licensees at Risk appeared first on Weil Bankruptcy Blog.

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In a recent opinion from the Bankruptcy Court for the Southern District of New York, Judge Glenn determined it was appropriate in three adversary proceedings to enter default judgments against foreign defendants that refused to answer the plaintiff’s summons and complaint. Kravitz v. Deacons (In re Advance Watch Co., Ltd.) offers a helpful tutorial for plaintiffs looking to serve process and other documents on foreign defendants. Moreover, the opinion confirms bankruptcy courts’ constitutional authority to enter final default judgments under Stern v. Marshall, and provides a warning to foreign defendants against taking an out-of-sight, out-of-mind approach to adversary proceedings in the U.S.

Background Facts

Peter Kravitz (the “Trustee”), the trustee for a creditor trust under the debtor’s confirmed chapter 11 plan, commenced avoidance actions against three foreign entities to recover prepetition preferential transfers of property. The defendants in the adversary proceedings – Deacons, Wheeler Corporation Ltd., and Display & Packaging Ltd. (each a “Defendant”) – all were domiciled in and subject to the laws of Hong Kong.

In each of the adversary proceedings, the Trustee took the same steps. First, he filed a complaint in the Bankruptcy Court and caused a summons to be issued to the Defendant, and then caused the bailiff’s assistant of the Hong Kong High Court to serve the summons and complaint on the Defendant. The Trustee also filed an accompanying proof of service.

Next, after not receiving a response to the complaint, the Trustee filed a request for entry of a certificate of default by the clerk of the Bankruptcy Court, which the clerk issued. The Trustee served the Defendant with the certificate of default by first class mail and filed an accompanying proof of service in the Bankruptcy Court. Still, the Defendant offered no response.

Finally, the Trustee filed a motion for entry of default judgment, supporting declaration, and notice of presentment of order for default judgment in the Bankruptcy Court. The Trustee served the Defendant with those documents by regular mail and filed an accompanying proof of service. Again, the Defendant offered no response.

Bankruptcy Court’s Authority to Enter Final Default Judgments

As a preliminary matter, Judge Glenn’s decision on whether to enter default judgments revolved around the interplay between Rule 55 of the Federal Rules of Civil Procedure1 and the Bankruptcy Court’s constitutional authority to enter final default judgments. Relevant here, Federal Rule 55(a) provides:

When a party against whom a judgment for affirmative relief is sought has failed to plead or otherwise defend, and that failure is shown by affidavit or otherwise, the clerk must enter the party’s default.

Rule 55(b)(1) further provides:

If the plaintiff’s claim is for a sum certain or a sum that can be made certain by computation, the clerk—on the plaintiff’s request, with an affidavit showing the amount due—must enter judgment for that amount and costs against a defendant who has been defaulted for not appearing and who is neither a minor nor an incompetent person.

Alternatively, under Rule 55(b)(2), a plaintiff may move for the bankruptcy judge rather than the clerk to enter a default judgment.

As readers of this blog know well, however, under the Supreme Court’s 2011 decision in Stern v. Marshall, bankruptcy courts lack constitutional authority to enter final judgments with respect to certain matters. Still, the Supreme Court clarified in Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015) that litigants can impliedly consent to having a bankruptcy court enter final judgments regarding such matters, so long as such consent is knowing and voluntary.

With that constitutional and procedural backdrop, and consistent with his prior rulings, Judge Glenn held that Bankruptcy Courts have the constitutional authority to enter default judgments based on implied consent when a defendant fails to respond to a summons and complaint, and as applied to the case before him, the Bankruptcy Court could enter final default judgments against the Defendants if:

  1. The (a) summons and complaint, (b) certificate of default, and (c) motion for default judgment, supporting declaration, and notice of presentment were all properly served on the Defendants; and
  2. The Trustee’s motion for default judgment was for a sum certain or made certain by computation.
Proper Service and Proofs of Service

To analyze whether the Trustee properly served the Defendants with the summons and complaint, Judge Glenn looked to Rule 4 of the Federal Rules of Civil Procedure.2 Rules 4(f) and (h) articulate service of process requirements on foreign corporations, allowing plaintiffs to serve “by any internationally agreed means of service that is reasonably calculated to give notice, such as those authorized by the Hague Convention on the Service Abroad of Judicial and Extrajudicial Documents.” The Hague Convention, in turn, provides that the central authority of the foreign state must serve the documents “by a method prescribed by its internal law for the service of documents in domestic actions upon persons who are within its territory.”

Separately, Rule 4(l)(2)(A) sets forth the proof of service requirements for foreign corporations, incorporating the requirements enumerated in the applicable treaty or convention. Here, the Hague Convention provides that the central authority of the foreign state must complete a form certificate, which “shall state that the document has been served and shall include the method, the place and the date of service and the person to whom the document was delivered.”

Applying these rules to the facts at hand, Judge Glenn found that the Trustee properly served the Defendants with the summons and complaint. This paragraph and the next paragraph set forth the example for one of the Defendants. In compliance with the Hague Convention and Hong Kong’s High Court rules of service of process, the Trustee caused the bailiff’s assistant to personally serve a summons and complaint on the Defendant at its Hong Kong address. The Defendant’s secretary voluntarily accepted the service. The Trustee then obtained and filed a certificate confirming the date and place that the summons and complaint were served on the Defendant, and supplemented the certificate with an affidavit from the bailiff’s assistant identifying the method and recipient of service. Taken together, these facts satisfied Rule 4’s service requirements.

Judge Glenn then looked to Rule 5 of the Federal Rules of Civil Procedure3 to determine whether the Trustee properly served the Defendants with the remaining documents. Compared to Rule 4, Rule 5(b) provides greater flexibility and allows service of non-process documents to be made by mailing documents to a person’s last known address. Here, the Trustee mailed each of the certificate of default, motion for default judgment, supporting declaration, and notice of presentment to the Defendant’s last known address. The Trustee also filed a separate certificate of service certifying that the documents were mailed to the Defendant at its last known address. Accordingly, Judge Glenn held that service of those documents was proper.

Sums Certain

Lastly, the Trustee’s motion for default judgment sought $14,558.55 plus interest and costs, with such amount supported by a declaration and bank statements. Satisfied that such amount was a “sum certain” for Rule 55 purposes, that service of summons and complaint and other documents was proper, and noting that the Defendants all failed to respond or otherwise appear in the cases, Judge Glenn concluded that entry of default judgments against the Defendants was appropriate.

Takeaways

For plaintiffs, Advance Watch offers an excellent walkthrough of the necessary considerations and steps for providing service to foreign defendants (although, of course, one should consult counsel about the particularities of any individual situation). But the case also serves as a reminder to foreign defendants to take bankruptcy court adversary proceedings seriously. Turning a blind eye toward notices may constitute implied consent to entry of an adverse final default judgment.

The post In Advance Watch, SDNY Bankruptcy Court Offers How-To Guide on Serving Process on Foreign Defendants and Applies Broad Implied Consent Standard under Stern and Wellness appeared first on Weil Bankruptcy Blog.

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Weil Summer Associate David Rybak contributed to this post

A creditor’s control of votes in a class of claims can be a powerful means of influencing the outcome of a debtor’s chapter 11 plan confirmation process.  The Ninth Circuit Court of Appeals’ recent decision in In re Fagerdala, 891 F.3d 848 (9th Cir. 2018) has sharpened a weapon in the arsenal of aggrieved creditors, holding that claims purchases by creditors aimed at acquiring a blocking position in a class of claims to influence the outcome of a chapter 11 plan process is not a per se act of bad faith.  Instead, a finding of bad faith requires evidence that a party acted with an “ulterior motive” beyond merely pursuing its enlightened self-interest to protect its economic interests.  Fagerdala expressly leaves the door open for such creditors to buy blocking positions against such plans, and to do so efficiently, so long as their motives do not cross the line.

Background

Fagerdala USA – Lompoc, Inc. (“Fagerdala”), the debtor, was a California corporation that owned real estate worth approximately $6 million.  Pacific Western Bank held a senior secured claim worth approximately $4 million, secured on Fagerdala’s real estate.

Fagerdala filed for chapter 11 on August 14, 2014, and filed a proposed chapter 11 plan of reorganization on April 27, 2015. Pacific Western Bank was not satisfied with the proposed treatment its secured claim under the proposed plan.  As we’ve discussed previously on this blog, a debtor can confirm a chapter 11 plan over the objection of a non-consenting class of claims, so long as, among other things, at least one class of claims that is impaired has voted to accept the plan.

Because Pacific Western Bank would not vote to accept the debtor’s plan, the plan could not be confirmed without an affirmative vote from the general unsecured claims class.  See 11 U.S.C. § 1129(a)(10).   The debtor sought to “cram up” its secured lender, Pacific Western Bank, by using the general unsecured claims class to achieve its requirement to have an impaired accepting class vote in favor of the plan.

As a defensive measure, Pacific Western Bank took steps to block Fagerdala’s plan by offering to purchase some, but not all, of the general unsecured claims against the debtor.  This effort was successful, resulting Pacific Western Bank acquiring 50% in number of the allowed general unsecured claims.  These claims represented less than 10% in value of all allowed general unsecured claims against the debtor (the “Purchased Claims”).  Pacific Western Bank then voted all of its claims – both secured and unsecured – against Fagerdala’s chapter 11 plan.1  In response, Fagerdala moved to designate the votes of the Purchased Claims under 11 U.S.C. § 1126(e), arguing that the Pacific Western Bank had not purchased them in good faith.

Primer on Vote Designation and Good Faith

Section 1126(e) of the Bankruptcy Code provides that “on request of a party in interest, and after notice and a hearing, the court may designate any entity whose acceptance or rejection of such plan was not in good faith, or was not solicited or procured in good faith or in accordance with the provisions of this title.”  When a claim is “designated,” the vote of the claim is no longer considered when determining whether a class of claims has voted in favor of a plan of reorganization.

Good faith is not defined in the Bankruptcy Code, and its interpretation has been left to the courts to develop.  Historically, however, courts have looked toward parties’ subjective motives, and the Ninth Circuit has previously held that section 1126(e) designation applies to those who “were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled. . . . An entity acts in bad faith when it seeks to secure some untoward advantage over other creditors for some ulterior purpose.”2

The Bankruptcy Court and District Court Holdings

The bankruptcy court granted Fagerdala’s designation motion, stating as a matter of law it was not going to consider Pacific Western Bank’s subjective motivation for not offering to purchase all general unsecured claims.  Rather, the bankruptcy court rested its decision solely on (i) the objective fact that Pacific Western Bank did not offer to purchase all general unsecured claims, and (ii) its finding that failing to designate the Purchased Claims’ votes would be highly prejudicial to the remaining creditors in the general unsecured claims class.  Perhaps deciding with equitable principles in mind, the bankruptcy court highlighted the fact that the general unsecured claims would certainly not be paid in any liquidation that might have followed the plan not being confirmed, but would be paid in full within 60 days of confirmation of the debtor’s proposed plan.  On appeal, the district court affirmed the bankruptcy court’s designation order.

The Ninth Circuit’s Holding

The Ninth Circuit reversed the judgment and vacated the bankruptcy court’s designation order.  Reviewing the bankruptcy court’s finding of bad faith—a question of fact—the Ninth Circuit applied a “clear error” standard of review.  The Ninth Circuit first reiterated that a finding of bad faith is appropriate where an entity has acted with some ulterior purpose.  In other words, a finding of bad faith must be grounded in that entity’s subjective motives.

Consequently, the Ninth Circuit found that the bankruptcy court committed clear error in its bad faith determination by ignoring Pacific Western Bank’s underlying motivations.  Pacific Western Bank’s selectivity in offering to purchase only a subset of general unsecured claims was not, in isolation, dispositive of an ulterior motive.  Nor was the “highly prejudicial” effect of Pacific Western Bank’s actions vis-à-vis other creditors sufficient to demonstrate that Pacific Western Bank acted with an improper ulterior motive.  Rather, a creditor may rightfully protect its claims to the fullest extent and if it “acted out of enlightened self-interest, it is not to be condemned simply because it frustrated the debtor’s desires.”3

The Upshot

The Ninth Circuit took a macro-approach in evaluating a “creditor’s self-interest” by looking to a party’s interests in the case as a whole rather than conducting separate analyses with respect to claims held in different classes.  This approach reflects the practical realities of creditors looking to maximize their overall position in chapter 11 proceedings, instead of forcing creditors to wear different hats and pursue their self interest within different, competing classes of claims.

In keeping with this practical approach, the Ninth Circuit gave several examples of an outside or ulterior benefit, which if sought, would support a finding of bad faith.  Such examples include (i) a non-preexisting creditor purchasing a claim for the purpose of blocking an action against it, (ii) competitors purchasing claims to destroy the debtor’s business in order to further their own, and (iii) a debtor arranging to have an insider purchase claims.

Fagerdala serves as a reminder that, at least in the Ninth Circuit, bad faith determinations under 11 U.S.C. § 1126(e) must tie into a party’s improper, subjective motivations. Conceptually, the Ninth Circuit reiterated the distinction between “a motive which is ulterior to the purpose of protecting a creditor’s interest” – a token of bad faith – and “a creditor’s self interest as a creditor” – a permissible motivation under the Bankruptcy Code.4  The decision supports the ability of creditors to purchase claims as a defensive maneuver to protect their economic interests, so long as their motives are not otherwise tainted by an ulterior benefit.

The post Upon Further Review, Ninth Circuit Finds No Flag On the Play – Creditor Allowed to Block a Cram-Up Plan Following Claims Purchases appeared first on Weil Bankruptcy Blog.

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Weil Summer Associate Candice Ellis contributed to this post

“All circuits…limit standing to appeal a bankruptcy court order to persons aggrieved by the order.”1.  A “person aggrieved” is defined as someone whose rights or interests are directly and adversely affected pecuniarily by the bankruptcy court order.2  Simply put, a party must have a financial stake in the matter and the bankruptcy court order at issue must have either increased the party’s burdens, or impaired its property or rights in some way.

The circuits are split on whether attendance and objection at a bankruptcy court proceeding are prerequisites to appellate standing under the “person aggrieved” standard.  The Tenth, Seventh, and Fifth Circuits have held that, provided there is proper notice, attendance and objection are prerequisites for a party to have standing to appeal.  The Ninth and Fourth Circuits have held that attendance and objection are not prerequisites. Many other circuits have declined to reach the issue, choosing to resolve and dismiss the controversy on the ground that the party was not a “person aggrieved.”

Prerequisites? 10th Cir., 7th Cir., 5th Cir. 9th Cir. 4th Cir.
Attendance at the Bankruptcy Hearing Strictly Required Not Required Not Required
Filed an Objection with the Bankruptcy Court Strictly Required Party must have objected in some form. Not Required.

In In re Parr, the Tenth Circuit found that the standard for appellate standing is appearance before the bankruptcy court and objection to the sale order in question.3  Though appearance was not at issue in this case, the Tenth Circuit found that the debtor lacked standing because it failed to file an objection or to challenge the sale order at issue in its response to the chapter 7 trustee’s sale motion (the debtor’s tardily filed response did not address the bankruptcy court’s sale order).  The Tenth Circuits holding here was in line with the Circuit precedent.4  The rationale behind maintaining attendance and objection as prerequisites is that it maintains judicial economy and efficiency.

Offering a different perspective, the Ninth Circuit held in Point Ctr., that appearance and objection are not prerequisites for appellate standing.  The standard is simply a demonstration that the bankruptcy order at issue directly and adversely affected the appellant pecuniarily.  But even the Ninth Circuit seems to weigh procedural considerations in its holding.  The Ninth Circuit deliberately noted that though the appellants had neither attended nor objected, the appellants had communicated their objections/challenges in a motion to the court.5  Further, the bankruptcy court considered the motion containing the appellant’s objections/challenges when it issued the order at issue.6  The Ninth Circuit limited its holding in Point Ctr. to those specific facts.  Thus, after considering the facts, it appears that the Ninth Circuit does require “objection” in some form, but not necessarily a filed objection for appellate standing.

The Fourth Circuit is at the other end of the spectrum.  In Urban Broadcasting, the Fourth Circuit held that appearance and objection have no bearing on appellate standing.  The court explained that to predicate standing on objection misconstrues the appellate standing requirement as defined within the Fourth Circuit.7  The standard for appellate standing in the Fourth Circuit is simply being directly and adversely affected by a bankruptcy court’s decision.  To demonstrate such a disposition does not require the appellant to have attended and made objections at the hearing; nor does it require the appellant to have previously notified the court of its “aggrieved” status in some other form.  Under the Urban Broadcasting holding, the range of parties who can assert standing in the Fourth Circuit is broad.

In conclusion, whether attendance and objection are prerequisites for appellate standing depends on what Circuit you are in. Only the Tenth, Seventh, and Fifth Circuits require attendance at the hearing where the bankruptcy court issued the order that aggrieved the appellant. The Tenth, Seventh, and Fifth Circuits require a party to have filed an objection with the bankruptcy court to have standing; or else the party waives the right to appeal. The Ninth Circuit seems to require that the party have communicated to the bankruptcy court its challenges to the appellee’s motion in some form, in order to have standing. Lastly, in the Fourth Circuit, there are no such prerequisites for appellate standing, a party need only to be an aggrieved person to appeal.   Although the law in different Circuits appears to differ, regardless of the Circuit where a particular controversy is heard, counsel is best advised to preserve clients’ rights by filing at the very least “placeholder” objections to motions that are likely result in bankruptcy court orders that the clients may seek to appeal.

The post Are Attendance and Objection in Bankruptcy Court Prerequisites for Appellate Standing? appeared first on Weil Bankruptcy Blog.

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Weil Summer Associate MJ Koo contributed to this post

In a recent decision, the Fifth Circuit narrowly held that federal law does not prevent a bona fide shareholder from exercising its voting right in the company’s charter to prevent the filing by the company of a bankruptcy petition merely because it is also an unsecured creditor.  In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 203 (5th Cir. 2018).  Although the Fifth Circuit did not make a broad ruling on the legality of provisions that give parties the ability to block a company’s filing of a voluntary bankruptcy petition (often called “golden shares” or “blocking provisions”), it touches on interesting issues of creditor and shareholder rights in that regard.

What happened in Franchise Services?

The Fifth Circuit Court of Appeals’ decision affirmed a bankruptcy court’s decision to uphold the validity of a blocking provision given to the equity holder of the debtor.

In this case, Macquarie, through a newly-created and fully-owned subsidiary, Boketo, made an investment of $15 million in Franchise Services of North America (the “Debtor”) in exchange for 100% of the Debtor’s preferred stock.  Separate from, but after, the $15 million equity investment, Macquarie billed the Debtor for consulting fees in the amount of $3 million.

As a condition for the equity investment, Macquarie had required the Debtor to amend its articles of incorporation to require consent from a majority of each class of the Debtors’ preferred and common shareholders before filing for bankruptcy (the “Shareholder Consent Provision”).  A few years later, the Debtor filed a bankruptcy petition without requesting or obtaining the consent of its shareholders, including Boketo.  The consulting fees of $3 million to Macquarie remained unpaid.

Macquarie and Boketo sought to dismiss the Debtor’s voluntary bankruptcy filing arguing that the Debtor failed to obtain the proper corporate authorization for a filing, as it did not get the consent of the required classes of shareholders as required by the Debtor’s certificate of incorporation.  The Debtor argued, among other things, that (i) the Shareholder Consent Provision was an invalid bankruptcy restriction contrary to federal bankruptcy policy, (ii) the Shareholder Consent Provision was unenforceable under Delaware law, and (iii) Boketo’s fiduciary obligations as a controlling minority shareholder prevented it from blocking the Debtor from filing for bankruptcy.

Fifth Circuit Opinion

The Fifth Circuit held that under federal bankruptcy law, simply being a creditor does not prevent a bona fide equity holder from exercising its right under a charter to block a bankruptcy filing, and under the facts of the case before it, Macquarie was a bona fide equity holder.  What is just as interesting, however, is what the Fifth Circuit did not decide.  For example:

  • The Fifth Circuit did not decide whether a contractual provision whereby a debtor waives its right to file bankruptcy is enforceable (although it noted that other Courts of Appeal, including the Seventh and Ninth Circuits, held such provisions to be unenforceable).
  • It similarly did not decide whether a provision in a charter that provides a creditor the right to veto a bankruptcy is enforceable (although it noted several cases that have held such provisions to be unenforceable).
  • It also explicitly did not decide whether a similar provision involving a nominal shareholder (where the equity interest is “just a ruse” to protect the party’s position as a creditor) would be enforceable.

The Fifth Circuit declined to rule on the question of the enforceability of the provision under Delaware law, due to, among other things, a lack of on-point Delaware cases.  It did suggest, however, that Delaware law would likely tolerate a provision in the certificate of incorporation that conditions the corporation’s right to file a bankruptcy petition on shareholder consent because Delaware law, being regarded as among the most flexible in the nation, provides parties “with great leeway to structure their relations, subject to relatively loose statutory constraints.”  Id. (citing Jones Apparel Grp., Inc. v. Maxwell Shoe Co., 883 A.2d 837, 845 (Del. Ch. 2004)).

In addition, the Fifth Circuit rejected the Debtor’s fiduciary duty argument and found that Boketo, which held 49.76% in equity interest, was not a minority-controlling shareholder because there was no evidence of actual control.  The Fifth Circuit held that Boketo’s sizeable equity stake was not dispositive and the power to veto the Debtor’s voluntary bankruptcy filing did not amount to actual control because Boketo never got a chance to exercise that right.  Rather, the Debtor’s board never put the bankruptcy matter to vote and filed for bankruptcy without the shareholders’ consent.  Even if Boketo had breached a fiduciary duty, the Fifth Circuit held that the bankruptcy court has “no power . . . to shift the management of a corporation from one group to another, to settle intracorporate disputes, and to adjust intracorporate claims. . . .”  Id. (citing Price v. Gurney, 324 U.S. 100, 106 (1945)).  The proper remedy for a breach of fiduciary duty would be a claim under state law.

Conclusion

Franchise Services touches on interesting questions faced by numerous courts regarding whether a creditor can block a bankruptcy filing pursuant to a corporate charter’s “golden share” provision or other contractual blocking provision.  There seems to be a general consensus that such rights that a creditor holds solely in respect of its debt claim are unenforceable, notwithstanding the Fifth Circuit’s reluctance to rule directly on that issue.  Conversely, as the Fifth Circuit held, those rights in the hands of an equity holder with a very small creditor position are enforceable.  But what about the gray area in between?  How much equity does a creditor have to hold to be the “bona fide” equity holder that the Fifth Circuit says is protected?  How important are the circumstances surrounding the creation of the debt and the equity interest?  Is it problematic if those two rights were created at the same time?  The Fifth Circuit leaves these questions for another day.

The post The Fifth Circuit Considers Enforceability of “Golden Share” Provisions in Franchise Services appeared first on Weil Bankruptcy Blog.

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In Momentive Performance Materials, the Second Circuit declined to dismiss as equitably moot the appeals of certain noteholders.  The decision highlights that successfully invoking the doctrine of equitable mootness may be difficult under prevailing case law where plan confirmation issues have been diligently appealed by parties in interest, even when a bankruptcy court has confirmed a complex plan of reorganization and the plan has gone effective.

Background

For context, Momentive Performance Material’s (“MPM”) capital structure included the following debt issuances:

  • Subordinated Notes. In 2006, MPM issued $500 million in subordinated unsecured notes (the “Subordinated Notes” and the holders of such notes, the “Subordinated Noteholders”). In 2009, MPM offered holders of Subordinated Notes the option of exchanging their notes for second-lien secured notes at a 60% discount.  Holders of $118 million of the Subordinated Notes accepted the offer, leaving $382 million in outstanding Subordinated Notes.
  • Second-Lien Notes. In 2010, MPM issued approximately $1 billion in “springing” second-lien notes (the “Second-Lien Notes” and the holders of such notes, the “Second-Lien Noteholders”).  These notes were unsecured up until MPM redeemed the $118 million of Subordinated Notes, which triggered a “spring,” granting noteholders a second-lien interest in certain collateral.
  • Senior-Lien Notes. In 2012, MPM issued two classes of senior notes: $1.1 billion in first-lien secured notes (the “First-Lien” Notes”) and $250 million in 1.5-lien secured notes (the “1.5-Lien Notes” and together with the First-Lien Notes, the “Senior-Lien Notes”).  Under the Senior-Lien Notes indenture, these noteholders were entitled to a “make-whole” premium if MPM opted to redeem the notes prior to maturity.

In 2014, MPM and its affiliated debtors filed chapter 11 proceedings.  MPM subsequently filed a plan of reorganization.  The Subordinated Noteholders and Senior-Lien Noteholders (together, the “Appellants”) opposed this proposed plan.  The Subordinated Noteholders, who did not receive any recovery under the plan, argued that their notes were not subordinate to the Second-Lien Notes under the terms of the governing indentures.  The Senior-Lien Noteholders opposed the plan on grounds that their replacement notes did not provide for the make-whole premium and had an interest rate far below the market rate of interest.

The bankruptcy court confirmed the plan over these objections, which triggered an automatic 14-day stay.  During this time, the Appellants moved in the bankruptcy and district courts to extend the stay pending their appeal, both of which were denied.  MPM’s plan subsequently went effective, with reorganized MPM and its affiliates emerging from chapter 11 under the terms of the confirmed plan of reorganization. The Appellants timely appealed the confirmation order to the district court and eventually to the Second Circuit.  MPM contended that the appeals should be dismissed as equitably moot.

Before diving into the opinion, let’s do a quick refresher on the doctrine of equitable mootness.  You can also check out previous Bankruptcy Blog articles on equitable mootness here, if you feel so inclined.

What is Equitable Mootness?

The doctrine of equitable mootness is grounded in the case or controversy requirement of Article III of the United States Constitution and, when applied in the bankruptcy context, is guided by equitable considerations.1  The doctrine allows appellate courts to dismiss bankruptcy appeals where, during the pendency of the appeal, events occur that result in the implementation of the relief sought being unfair or unjust, even if effective relief could be fashioned.2

In chapter 11, equitable mootness challenges often arise where, as in Momentive, a party seeks to appeal issues related to a “substantially consummated” chapter 11 plan.3  In the Second Circuit, once a plan has been substantially consummated, an appeal of that plan becomes presumptively moot and the burden shifts to the appellant to demonstrate five factors enumerated in In re Chateaugay Corp. to overcome that burden, namely that (i) effective relief can be ordered; (ii) such relief will not affect the debtor’s re-emergence; (iii) the relief will not “unravel intricate transactions”; (iv) the affected third-parties are notified and able to participate in the appeal; and (v) the appellant diligently sought a stay of the reorganization plan.4

Although satisfaction of each Chateaugay factor is necessary to overcome the presumption of mootness, reviewing courts have placed great weight on the fifth factor, referring to it as a “chief consideration.”5  In fact, the Second Circuit has previously concluded that if stay of a confirmation has been sought relief should be provided so long as it is “at all feasible,” or, in other words, it would not “knock the props out from under the authorization for every transaction that has taken place and create an unimaginable, uncontrollable situation for the Bankruptcy Court.”6

Equitable Mootness Arguments in Momentive

1.  MPM’s Arguments in Favor of Dismissing Appeals as Equitably Moot

MPM along with other parties, including Apollo Management LLC and certain affiliated funds (“Apollo”) and the ad hoc committee of Second-Lien Noteholders (collectively, the “Appellees”), asserted that the Appellants failed to demonstrate (i) the Court could grant effective relief without upending critical elements of the compromise underlying the plan, and (ii) reversal of the plan would not cause debilitating financial uncertainty.

First, the Appellees asserted that the plan was the product of a “highly complex economic settlement” between MPM and 85% of the Second-Lien Noteholders.  The Appellees pointed to the fact that certain of the creditor-Appellees played a key role in the bankruptcy by agreeing to (i) accept equity in the reorganized debtor, (ii) backstop and participate in a $600 million rights offering, which raised funding necessary to make distributions under the plan, and (iii) forego a billion-dollar deficiency claim, allowing 100% recoveries for unsecured creditors.  The Appellees noted that if Subordinated Noteholders were to prevail on their subordination appeal, MPM would owe Subordinated Noteholders approximately $382 million, which would either significantly dilute the equity stake that Second-Lien Noteholders received under the plan, and/or require MPM to provide Subordinated Noteholders with additional cash payments.  The Appellees argued that this would effectively impose a different plan of reorganization than the one they had voted in favor of and would deprive them of the benefits of their bargain without an opportunity to reevaluate concessions made, such as allowing general unsecured creditors to be paid in full.

Next, the Appellees urged that a recalibration or redistribution remedy would “unravel intricate transactions” so as to disrupt every transaction that had taken place since confirmation of the plan.  The Appellees pointed to the rights offering that had taken place and noted that trading of reorganized MPM’s stock had commenced, among other things.  The Appellees also asserted that implementing a recalibration or redistribution remedy would be difficult, as an entirely new plan would need to be confirmed.

Finally, the Appellees asserted that concessions made during plan negotiations were instrumental to MPM’s reorganization and could not be reversed without ruining the prospects of a successful future following emergence from chapter 11.  The Appellees warned that renewed negotiations would cast a cloud of uncertainty over MPM’s financial viability and operations, and they argued that a successful subordination appeal would require an extensive and time-consuming valuation hearing to determine the extent that Second-Lien Noteholders were secured.

2.  Subordinated Noteholder Arguments Against Dismissing Appeals as Equitably Moot

The Subordinated Noteholders argued that effective relief could be fashioned through a recalibration or redistribution, in that the Court could order (i) Second-Lien Noteholders to turn over distributions made to them under the plan, (ii) MPM to provide additional distributions such as cash payments or debt issuances, or (iii) a combination of both.

The Subordinated Noteholders first attacked the Appellees’ argument that the relief requested would unravel the plan, stating that a recalibration of recoveries was not inequitable as it would restore a lawful balance between creditor groups.  The Subordinated Noteholders challenged the notion that the plan was the result of a highly complex settlement, pointing to the fact that the rights offering was quite lucrative, that general unsecured claims were worth only two percent of the Second-Lien Noteholders’ claims, and that paying smaller creditors for their goodwill was normal in large chapter 11 cases.

The Subordinated Noteholders also expressed doubts that financial destabilization would occur given that relief could come from a recalibration of distributions to Second-Lien Noteholders rather than from MPM simply owing Senior Subordinated Noteholders $382 million.  Finally, the Subordinated Noteholder Appellants pointed to the fact that they had diligently sought stay of the confirmation order in three courts and alleged that the appellees had thrown up “roadblock after roadblock” to prevent a speedy resolution of the issues in dispute.  Accordingly, the Appellants argued that the fifth Chateugay factor pointed decisively in their favor and that it would be inequitable for the Second Circuit to decline to exercise its jurisdiction to decide the appeal.

3.  Key Arguments of Senior Secured Noteholders Against Dismissing Appeals as Equitably Moot

The Senior Secured Noteholders also highlighted that they had diligently sought a stay of the confirmation order and that the Court could fashion all of the relief required by recalibrating the interest rate on replacement notes, which would not unwind any of the plan effective date transactions.  They pointed out that the relief they sought was directly provided for in the plan and, therefore, part of the highly complex settlement negotiated by Appellees.  With respect to the diminished value of equity, First-Lien Appellants asserted that MPM had assumed that risk and noted that the disclosure statement had warned of lower equity value than anticipated in the event that MPM was required to pay a greater interest rate on replacement notes or a make-whole premium.  Finally, the First-Lien Appellants asserted that paying a greater cramdown interest rate or make-whole premium would not force MPM back into bankruptcy, as MPM had testified to the plan’s feasibility even if such things were to occur.

The Second Circuit’s Holding

The Second Circuit agreed with the lower courts and denied MPM’s request to dismiss the appeals as equitably moot.  The Court found that, in light of the limited scope of the remand ordered and the scale of MPM’s reorganization, it did not believe the plan would unravel or the prospects of MPM’s emergence from chapter 11 would be threatened.  The Court found that the only recalibration required was to evaluate the interest on the replacement notes to Senior-Lien Noteholders.7  Notably, the Court highlighted the fact that Appellants immediately objected to several provisions in the plan and diligently sought a stay of the confirmation order.  The Second Circuit noted that lower courts that were intimately familiar with MPM’s financial situation, though not making any determinative ruling, had stated that the risk of equitable mootness did not seem great with respect to either the Senior Subordinated Noteholders or Senior-Lien Noteholders.

Closing Thoughts

Momentive provides useful insight on the second and third Chateaugay factors ((2) relief will not affect the debtor’s re-emergence and (3) relief will not “unravel intricate transactions.”)  As outlined above, MPM argued for a doom-and-gloom scenario where the plan would unravel and MPM’s prospects for success would nose-dive if a recalibration or redistribution were required.  This was in hopes that the Second Circuit would come to a similar conclusion as it did in In re Charter Commc’ns Inc.8 In Charter, the Second Circuit found that a settlement between a majority equity holder and a group of bondholders formed a critical component of a pre-negotiated chapter 11 plan, and that the settlement could not be altered to remove third-party releases and compensation provided to the equity holder under plan without throwing the viability of the plan into doubt.9

Charter and Momentive thus appear to stand on opposite ends of the spectrum with respect to the second and third Chataeugay factors.  In both cases, appellant(s) had diligently sought a stay of the confirmation order (the “chief” Chateaugay factor).  The difference was that the court in Charter believed the second and third factor were sufficiently manifest to strike down the appeal as equitably moot.  In Momentive, however, the ability to recalibrate or redistribute recoveries under the plan and relatively minor impact such recalibration would cause in light of the scale of the case was not enough to persuade the Court that the prudential doctrine of equitable mootness should be invoked.

Parties considering equitable mootness challenges during plan appeal battles in the Second Circuit would be wise to consider these two cases to evaluate where they stand on the spectrum and the merits of their cases, especially in large chapter 11 cases, where parties are represented by sophisticated counsel who likely acted diligently in seeking a stay of the plan of reorganization.

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Weil Bankruptcy Blog by Weil Bankruptcy Blog - 1M ago

We mourn the loss of our partner, colleague and friend Stephen A. Youngman, who passed away on May 14 after a courageous battle with cancer. Steve was a member of Weil’s Business Finance & Restructuring practice and one of the editors of the Bankruptcy Blog. He joined the Firm’s Dallas office almost 30 years ago and spent nearly his entire career at Weil. He was a caring colleague, a distinguished lawyer and a beloved friend to many. He will be remembered for his free, easy and quiet demeanor, his clever sense of humor and for always making time to advise and support others. He graduated with a B.S. from Northwest Missouri University in 1982 and earned a J.D. from Southern Methodist University Dedman School of Law in 1985. We will remember Steve with the utmost respect and offer our sincerest condolences to his wife, Denise. He will be greatly missed by his many friends and colleagues at Weil, on this Bankruptcy Blog, and beyond.

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For millennia usury (defined as any interest on a loan, not just interest above some prescribed rate) was condemned as immoral in almost every culture (and in some it still is). Even such great thinkers as Aristotle disapproved of the charging of interest, describing it as the “most unnatural” means of “getting wealth” because it “makes a gain out of money itself, and not from the natural object of it.”1 In the United States, of course, compensating a lender for making a loan seems a completely natural and expected part of finance; and usury is a term that typically now only refers to the charging of interest in excess of that permitted by applicable law. But usury, however defined and regardless of the rate at which the concept kicks in, remains a subject of state specific opprobrium. Indeed, those states that proscribe usurious rates of interest typically declare the charging of usurious interest as being contrary to a fundamental public policy of the applicable state. And the penalties for violating these proscriptions can be severe, including in certain circumstances the forfeiture of the principal advanced.

Even a state like New York, which is popularly believed to be free of usury-related concerns, has severe penalties for loan transactions declared to be usurious. The rules for loans in an amount less than $2.5 million are actually quite complicated (and subject to several specifically defined exceptions depending on the nature of the borrower and the security for the loan), but in general if the loan is for an amount less than $250,000 the civil usury ceiling is 16% and charging interest in excess of 25% is a criminal offense. For loans of more than $250,000, but less than $2.5 million, the civil limit of 16% is not applicable but the 25% criminal limit remains applicable. It is only if a loan is for an amount of $2.5 million or more that usury limits, both civil and criminal, no longer apply (and a loan for $2.5 million that is to be advanced in installments by one or more lenders to a single borrower pursuant to a written agreement counts as being a loan for more than $2.5 million).2 And states like Texas have usury limits that apply even to loans greater than $2.5 million (the current limit for written loan agreements is generally 18%, subject to some exceptions).3

But it is important to note that it is not just the stated rate that can count as interest, any other compensation for the “use, forbearance or detention of money,” such as fees, grants of equity, the amount of any debt of others assumed, or just about any other contractually extracted consideration tied to the loan, might well be counted as interest too (although Texas has certain specified statutory exceptions for equity grants, loan assumptions and other common lender add-ons for certain specifically defined types of loans4). And what constitutes a loan as opposed to an investment or purchase is a fact specific exercise. In general, any transaction that requires the absolute repayment of the funds advanced is subject to the risk of being re-characterized as a loan.

A recent Delaware Superior Court decision, Change Capital Partners Fund I, LLC v. Volt Electrical Systems, LLC, C.A. No. N17C-05-290 RRC (Del. Super. Ct. April 3, 2018), provides an opportunity to remind private equity and restructuring deal professionals and their counsel of the importance of considering state specific usury laws in structuring (or restructuring) transactions that are loans, or might be re-characterized as loans, as well as the importance of appropriately selecting the most favorable governing law that is available for such a transaction. In Change Capital Partners, Azadian Group, LLC (Azadian”) had entered into a Merchants Receivables Purchase and Security Agreement with Volt Electrical Systems, LLC (“Volt”), pursuant to which Azadian had agreed to purchase $472,500 of future receivables to be generated by Volt for a fixed purchase price of $338,000. Volt paid Azadian the fixed purchase price of $338,000, but Volt apparently only transferred $248,590 in receivables to Azadian, leaving Azadian short by $223,910 of untransferred receivables. Azadian thereafter transferred its rights under the receivables purchase agreement to Change Capital Partners, a private equity firm. Change Capital Partners then sued Volt for breaching the receivables purchase agreement by failing to transfer the additional $223,910 of Volt receivables.

In defense, Volt claimed that the receivables purchase transaction was actually a loan and that the interest charged on that loan (presumably the receivables to be transferred in excess of the $338,000 actually advanced) was a staggering 102%. Obviously, if true, the deemed interest rate was well above the maximum rate allowed under Texas law and, given that the amount of the alleged loan, $338, 000, would have been well below $2.5 million, that interest rate would have also been well above the 25% criminal usury rate under New York law. Volt further claimed that despite the fact that the receivables purchase agreement had a Delaware choice of law clause, that choice of law was invalid because (1) the receivables purchase agreement/loan was usurious under both Texas and New York law, both states with substantial relationships to the transaction and either of which would be the “default state,” whose law would govern in the absence of the contractual choice of Delaware law, (2) usury was contrary to the public policy of both Texas and New York, and (3) Delaware “recognizes that allowing parties to circumvent state policy-based contractual prohibitions through the promiscuous use of [Delaware choice of law] provisions would eliminate the right of the default state to have control over the enforceability of contracts concerning its citizens.” Upholding the Delaware choice of law clause was critical to eliminating further concern with Volt’s usury claims because Delaware, unlike Texas and New York, “provides no cap on interest rates, but instead allows interest to be charged in an amount pursuant to the agreement governing the debt.” In other words, if Delaware law applied any re-characterization of the receivables purchase transaction into a loan would have been irrelevant to the claim of usury as a defense to the enforcement of that agreement.

Ultimately the court rejected Volt’s efforts to override the Delaware choice of law clause because even though the court agreed that a usurious agreement would violate a fundamental public policy of both New York and Texas, Volt failed to show that either Texas or New York had a “materially greater interest” in the enforcement of the receivables purchase agreement/loan than did Delaware. The fact that Volt was Texas limited liability company based in Texas, and that the alleged loan was “originated and was funded by Azadian in New York” where “Azadian was headquartered,” was not deemed a materially greater interest for Texas or New York than the fact that Azadian was a Delaware LLC and the agreement contained a Delaware choice of law clause. Indeed, according to the court, “Title 6, section 2708(a) of the Delaware Code recognizes that a choice of law clause is a significant, material and reasonable relationship with [Delaware] and shall be enforced whether or not there are other relationships with [Delaware].”5

The choice of law for an agreement alleged to be a loan was deemed distinguishable from a prior case, Ascension Ins. Holdings, LLC v. Underwood, 2015 WL 356002 (Del Ch. Jan 28, 2015), where a Delaware choice of law clause was contained in an agreement respecting a non-compete by a California employee, in favor of Delaware corporation doing business almost entirely in California. California generally views non-competes as contrary to a fundamental public policy (similar to the view of New York and Texas respecting usury). But according to the court, “[a] loan is not akin to the non-compete clause in Ascension wherein the geographic scope of the non-compete necessarily invoked California.” And unlike a California-focused non-compete, “[t]here is no state, by virtue of the loan itself, that would clearly apply” absent the choice of Delaware law.

Blindly choosing New York law to apply to the receivables purchase agreement without considering the potential applicability of New York usury law may have resulted in a different outcome for the private equity firm assignee of Azadian’s receivables purchase transaction. It may be that the receivables purchase would not have been re-characterized and all would have been well, but by choosing Delaware law rather than New York, the issue became irrelevant. Never assume that New York is like Delaware with no usury limits just because most of the transactions that you have been involved with are for amounts in excess of $2.5 million. Sometimes private equity firms do in fact transact with portfolio companies or their management at levels less than $2.5 million, particularly in a situation where the portfolio company is in financial distress.6 Choosing Delaware law (coupled with a Delaware choice of forum clause)7 may be an appropriate default choice in such circumstances. After all, there is almost always an available Delaware entity to advance the funds pursuant to the agreed structure.

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It’s been an interesting couple of weeks for bankruptcy at the United States Supreme Court with two bankruptcy-related decisions released in back-to-back weeks. Last week, the Supreme Court issued an important decision delineating the scope of section 546(e) of the Bankruptcy Code (discussed here [1] for those who missed it). Then again, this week, on March 5, 2018, the Supreme Court issued a somewhat strange (in the authors’ view) decision involving “non-statutory insider” determinations in the Bankruptcy Code context. See U.S. Bank Nat’l Ass’n v. Village at Lakeridge, LLC, No. 15-1509, 2018 WL 1143822, at *1 (U.S. Mar. 5, 2018).[2]  The Lakeridge opinion purports to address only a narrow legal question: whether the Ninth Circuit Court of Appeals applied the proper standard of review in analyzing a bankruptcy court’s determination that a creditor was not a non-statutory insider. On that narrow question, the Court concluded that the Ninth Circuit appropriately reviewed the mixed question of law and fact on a “clearly erroneous” basis given the test articulated by the Ninth Circuit for determining non-statutory insider status.  More interestingly, as highlighted by two concurrences, Lakeridge raises further questions as to how lower courts should evaluate whether a person qualifies as a non-statutory insider under the Bankruptcy Code, an issue that could have implications in various contexts in chapter 11 cases where insider status matters. These include plan voting (at issue here), fraudulent transfer and preference analyses, severance payments, and KERPs. And from a purely entertainment perspective, the facts of the case are somewhat fun and juicy.

Insider Status
As a quick primer, section 101(31) of the Bankruptcy Code provides specific examples of who qualifies as an “insider,” including directors, officers, and controlling persons of a debtor. However, courts have long held that it is not an exhaustive list, and that other unenumerated persons can still qualify as “non-statutory insiders.” Some courts have developed different tests to determine who qualifies as a non-statutory insider, although the Supreme Court has not yet endorsed any of those tests.

Case Background
In this case, the debtor, Village at Lakeridge (the “Debtor”), had two major creditors, each separately classified under the Debtor’s chapter 11 plan:  (i) U.S. Bank – a creditor owed over $10 million, and (ii) MBP Equity Partners – the Debtor’s sole owner and thus a statutory insider, (See 11 U.S.C. § 101(31)(B)(iii)), owed $2.76 million. The Debtor sought to cram down a plan over U.S. Bank’s objection, (See 11 U.S.C. § 1129(b)), but ran into the obstacle that any such plan still required the consent of an impaired class of claims and the vote of MBP, an insider, would not suffice.  See 11 U.S.C. § 1129(a)(10).

The Debtor resolved this issue through a creative workaround. Kathleen Barlett, a member of MBP’s board and an officer of the Debtor, caused MBP to sell its claim to Robert Rabkin, Bartlett’s romantic partner, for $5,000 and Bartlett then voted the claim to accept the Debtor’s plan. Rabkin was clearly not a statutory insider, and despite an objection from U.S. Bank, the bankruptcy court concluded after an evidentiary hearing that he was not a non-statutory insider either. The bankruptcy court based its decision in part on its finding that Rabkin purchased the MBP claim as a speculative investment for which he performed adequate due diligence. The Ninth Circuit affirmed on appeal, first holding that a creditor qualifies as a non-statutory insider only if it meets two criteria: “(1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in § 101(31), and (2) the relevant transaction is negotiated at less than arm’s length.” In re Village at Lakeridge, LLC, 814 F.3d 993, 1001 (9th Cir. 2016) (citing Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1277 (10th Cir. 2008)). After finding that the bankruptcy court based its holding on the second prong of that test (i.e., that the transaction with Rabkin was at arm’s length), the Ninth Circuit affirmed the bankruptcy court’s decision under a clear error standard of review.

Supreme Court Opinion
The Supreme Court granted certiorari to answer a single, narrow issue: whether the Ninth Circuit was right to apply a clear error (rather than de novo) standard of review. In fact Justice Kagan, writing for Court, expressly acknowledged that the Court’s opinion “do[es] not address the correctness of the Ninth Circuit’s legal test; indeed we specifically rejected U.S. Bank’s request to include that question in our grant of certiorari.”  Lakeridge, 2018 WL 1143822 at *4.

The Court began by offering a general legal principal that the proper standard of review for mixed questions of law and fact depends on which court is better positioned to answer such questions.  See Lakeridge, 2018 WL 1143822 at *5 (citing Miller v. Fenton, 474 U.S. 104, 114 (1985)). Appellate courts are better suited to answering questions that may require expounding on the law, and in such instances a de novo standard of review should apply. In contrast, where mixed questions rely upon case-specific factual issues, trial court determinations deserve greater deference through a clear error standard of review. Because the bankruptcy court’s decision was based on a fact-intensive inquiry—whether Rabkin’s purchase of the MBP claim was an arm’s length transaction—the Court found that the Ninth Circuit was correct to apply a clear error standard of review.

Concurrences
The concurrences in the case (supported by four of the nine Justices) raise the question, admittedly not before the Court, of whether the Ninth Circuit’s test for non-statutory insider status is the correct approach.

Justice Kennedy wrote a brief concurrence to reiterate that the Court was not necessarily endorsing the Ninth Circuit’s test. He expressed some concern with the Ninth Circuit’s two-pronged inquiry, but suggested that Courts of Appeals should continue tinkering with different analyses to develop a better approach.

In a separate concurrence joined by Justices Kennedy, Thomas, and Gorsuch, Justice Sotomayor offered a more pointed perspective. In her concurrence, Justice Sotomayor took particular issue with the second prong of the Ninth Circuit’s test, noting that statutory insiders are unable to cleanse their votes by engaging in arm’s length transactions. Instead, she suggested that a better overall approach might be to look solely to a comparison between the characteristics of the alleged non-statutory insider and the statutory insiders to see whether they share sufficient commonalities. Alternatively, another acceptable approach might focus on a broader comparison that includes consideration of the circumstances surrounding any relevant transaction. Still, careful not to decide the appropriate test for determining whether a creditor qualifies as a non-statutory insider, Justice Sotomayor concluded by noting that a different standard of review might apply if the “correct” test was different from the one adopted by the Ninth Circuit.

Conclusion
One lesson here is that if your strategy is to sell your claim to avoid insider status, don’t sell it to someone with whom you have a romantic relationship. Not only might it defeat the goal of avoiding insider status (although in this case the parties escaped that consequence), but the details of your romantic relationship could also end up enshrined in the annals of the Supreme Court forever (a fate which the two lovebirds in this case did not escape).

On a more serious level, Lakeridge provides little binding guidance as to how lower courts should evaluate whether a creditor is a non-statutory insider under the Bankruptcy Code. Although it is clear that at least four Justices have reservations about the Ninth Circuit’s test, there is no consensus view as to a better approach, nor what standard of review would apply to such an approach.  Lakeridge’s main takeaway seems to be that Courts of Appeals will likely continue experimenting until they land on a test that the Supreme Court is ready to endorse.

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Yesterday, the United States Supreme Court, in Merit Management Group, LP v. FTI Consulting, Inc., Case No. 16-784, ruled that the “securities safe harbor” under section 546(e) of the Bankruptcy Code, 11 U.S.C. §§ 101-1532, does not shield transferees from liability simply because a particular transaction was routed through a financial intermediary—so-called “conduit transactions.”

  • Prior to Merit Management, a number of lower courts, including the United States Court of Appeals for the Second Circuit, had ruled that a transfer routed through a financial institution would, in effect, immunize the ultimate beneficiary of that transfer from avoidance on a constructive fraud theory. See, e.g., In re Quebecor World (USA) Inc., 719 F.3d 94, 100 (2d Cir. 2013).
  • In June 2016, the United States Court of Appeals for the Seventh Circuit rejected application of the 546(e) safe harbor in this manner in FTI Consulting Group, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).
  • The Supreme Court subsequently granted certiorari to resolve the split.

Like the Seventh Circuit, the Supreme Court rejected a broad-based application of 546(e).

  • Instead, the Supreme Court ruled that recipients of fraudulent transfers cannot, in effect, evade liability simply because a transfer was routed through a financial (“conduit”) institution.
  • In this analysis, the Supreme Court further rejected any application of section 546(e) that might involve a ‘step-by-step’ approach to limit liability. Rather, “[i]f a trustee properly identifies an avoidable transfer, . . . the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power.” Merit Mgmt., slip op. at 14.
  • In other words, the ultimate beneficiary of an avoidable transfer will not be immune from liability under section 546(e) simply by using a financial intermediary.

The Supreme Court was careful to note, however, that the section 546(e) safe harbor should still shield financial institutions in their role as intermediaries in this process.

  • For example, “[i]f the transfer that the trustee seeks to avoid was made ‘by’ or ‘to’ a securities clearing agency . . . , then § 546(e) will bar avoidance, and it will do so without regard to whether the entity acted only as an intermediary.” Merit Mgmt., slip op. at 17.
  • As a result, Merit Management should not signal an increased risk profile for financial institutions operating as conduits for financial transactions (e.g., escrow agents, clearinghouses, etc.)—notwithstanding the narrow scope applied to section 546(e) elsewhere in that opinion.

That said, Merit Management raises the question as to how state law preemption will be applied in light of the Supreme Court’s now-narrow application of section 546(e).

  • In 2016, the Second Circuit ruled that a broad range of state-law creditor remedies, such as constructive fraudulent transfer claims, were preempted by section 546(e). See In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 118 (2d Cir. 2016).
  • This ruling has been appealed, with a request for certiorari pending before the Supreme Court.
  • More recently, lower courts within the Third Circuit have rejected the Second Circuit’s approach on section 546(e)’s preemptive effect. See, e.g., In re Physiotherapy Holdings, Inc., 2016 WL 3611831 (Bankr. D. Del. June 20, 2016).
  • It remains to be seen whether, if at all, Merit Management will affect the Supreme Court’s consideration of the preemption issue.
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